The policy of zero salvage value overstates the periodic depreciation to some extent, however such amount is very insignificant. The machines and equipment can have fair value when they are discarded due to obsolescence. Certain transport equipment do have some fair salvage value. For the purpose of deprecation, the acquisition cost of an asset is reduced by the estimated salvage value.
Selection of depreciation method: The depreciable value of an asset is allocated over its estimated service life on some systematic and rational manner. The allocation is made on the basis of various depreciation methods. The selection of the depreciation method has a direct bearing on the amount of depreciation which is provided during a particular accounting year, e.g. in case of straight line method the amount of yearly depreciation will remain same through the service life of an asset, while under the diminishing balance method or sum of years digit methods the amount of depreciation will be higher in the initial period and will be lower in the ending period. Thus, selection of the depreciation method substantially affects the allocation of depreciation value over the service life an asset. This phenomenon is explained in the following paragraphs under methods of depreciation.
Methods of Depreciation:
There are a number of systematic depreciation methods that allocate the depreciabled value of an asset over its service life on some rational basis. As the selection of the depreciation method largely affects the yearly provision of depreciation the selection of appropriate method is an important decision. Depreciation methods are classified as under:
Methods based on time:
(1) Straight line method (2) Diminishing balance method (3) Sum of years digit method
Compound interest methods:
(4) Sinking fund method (5) Annuity method.
Method based on output:
(6) Unit of output method
(7) Retirement method (8) Replacement method
Methods based on time
The important methods of depreciation based on the time factor are: (1) Straight lien Method (SLM); (2) Diminishing Balance Method (DBM); (3) Sum of Year’s digit Method (SYDM).
Each of method is explained in brief as under:
Straight Line Method (SLM)
Under this method, the total depreciable amount over the life of the asset is apportioned on yearly basis. The fixed amount of depreciable is provided every year. Thus straight line method averages out the depreciation charge over the life of the asset. The yearly amount of depreciation is determined as under:
D = AC – SV / N
Where AC = Acquisition cost
SV = Scrap value at the end of useful life
N = Number of years of useful life
D = Yearly amount of depreciation
A machine costing Rs 12,000 was purchased on 1st January 1980. The useful life of the machine is expected to be ten years. The scrap value o the machine at the end of the useful life is Rs 2,000. The yearly depreciation that can be provided under the SLM will be ascertained as under:
D = AC – SV / N = 12,000 – 2,000 / 10 = Rs 1,000
Thus, every year Rs 1,000 will be charged to the profit and loss account. The main objection against this method is that it charges the depreciation on equal basis while the contribution of the asset to the profitability of the business year after year. The new asset contributes substantially to the profitability of the business and requires very little of the repairs and maintenance expenses. The process is reversed in the later years. However, these factors are not considered under SLM as fixed amount of depreciation is provided each year.